A Guide to Grass Roots Investing: How to Select Individual Stocks

Every year I take part in a March Madness betting pool. Usually the pool consists of 15-20 individuals who pay a buy in fee and then unconfidently pick how every game in the 64 team tournament will play out. If you haven’t seen a bracket of this size here is what it looks like:

Typically, I will make some initial selections based on which teams I am familiar with. After that I compare seeding with Vegas rankings, followed by looking at statistics and scheduling strengths associated with lesser known schools in the tournament. This is my personal method, but no one has ever established a “right way” to choose. That’s because sporting events, much like the stock market, are unpredictable because they don’t always behave logically.

The contrarian of the betting pool

A few years ago, a gal from our office joined our bracket pool to be part of the workplace camaraderie. She was the only female who participated. As luck would have it, she went on to correctly predict three of the “final four” teams and claim the pot of money.

When I asked her how she chose the teams who were going to compete in the Final Four she explained that she had attended Michigan State University, whose basketball team is led by the legendary coach Tom Izzo. During her undergrad studies, my co-worker gained firsthand insight from players as to what made Izzo such a successful head coach. From these interactions she concluded that Izzo is an extremely likable, gregarious and caring man. Most importantly though, she related these characteristics with Izzo being unbelievably successful in an area not known for powerhouse basketball.

So what did she do next?

She Googled other famous coaches who had teams with lower seeds in that year’s tournament. She specifically sought to determine which coaches were the nicest and most wholesome. Based on her findings, she chose their teams to make it to the Final Four.

An unusual approach to building a March Madness bracket? Sure. But it might not be as crazy as it sounds.

Highly educated financial advisors will always work to convince the general public that they have a magical truth serum used to select individual stock investments. But similar to picking winners in the NCAA Tournament, there’s no proven way to do it. That’s why a grass roots approach to investing, when applied systematically can be viable.

What is Grass Roots Investing?

I would describe Grass Roots Investing as gathering ground-level data to determine whether you want to invest in individual stocks. Simply put, gathering organic data related to a company or its products and services can help you formulate an impression and evaluate an organization, its business model, and its unique attributes.

Let’s say there’s a publicly traded company that sells freshly baked cookies. There’s a chance that a grass roots investor has tasted most of the flavors that company has to offer. In addition, if that individual visited one of their storefronts, he or she is probably familiar with the level of customer service that the company provides.

Gaining firsthand knowledge and experience can allow for a more complete and intimate understanding of a potential investment. Plus, it allows a lay person to formulate an opinion in a language that’s more relatable than the terminology contained in company financial statements.

To be clear though, the grass roots impressions and experiences are only part of the equation. Those impressions should always be followed up with some financial and background data to corroborate (or refute) your ground-level observations.

Four-Step Approach to Grass Roots Investing Research

Here’s the four-step process I use to implement my grass roots approach to investing:

I start by finding a company I like, believe in, or support. I’ll record the reasons why I’m enthusiastic about that organization.

Next, I’ll do some research to see the characteristics that make me so passionate about my company are exhibited by their industry competitors. This will help me determine if my company is unique or just like the rest of the competition.

I’ll dig into the numbers and do some financial research on my company of interest.

Finally, I will decide if investing in the company is a good idea.

A Grass Roots Investing Case Study with Southwest Airlines

While the four steps I’ve described above aren’t that complicated, there are some nuances to the process that I want to share with you. So, let’s walk through a real-life situation where I applied my grass roots approach to investing. I recently took a trip with Southwest Airlines – an airline I’ve always been impressed with – so follow along as I apply a grass roots approach to decide if Southwest Airlines is a good investment for me.

Step 1. What are my first-hand experiences and observations of Southwest?

My observations of Southwest have contrasted dramatically with my experiences on other airlines. Small nuances like not using a drink cart that runs over your toes in the aisle, allowing open seating, and refusing to charge customers for making changes to their trip have more of an effect than people realize.

Southwest’s marketing model of Transfarency has also struck a chord with me, as I can think of countless experiences where other airlines have found all sorts of ways to nickel and dime me. This transparency model is further backed by never levying hefty checked bag surcharges or exponentially raising flight costs as the departure dates nears.

To me, Southwest’s most apparent and overarching characteristic is probably their simplicity. Their transparent way of doing business reverberates throughout the entire organization. Reducing the administrative burden on employees leads to happier staff and customers.

Southwest also adds a personal touch to their in-flight activities. Ever noticed how their announcements seem to be more humorous and spontaneous? Southwest seems to promote individuality and fun – a far cry from the scripted, almost robotic announcements you try to tune out on other airlines.

In addition to my in-flight experiences, I’ve also had the pleasure of knowing a few people who have worked for Southwest. By all accounts, the company treats their employees remarkably well. These assertions are largely supported by websites like Glassdoor.

My final major observation is that there appears to be a high – and possibly increasing – demand for their services. I initially looked into Southwest’s plans for expansion because it seems like every time I’m on a Southwest flight there’s an announcement about new cities they are flying to. In fact, it seems reasonable to expect the organization to continue its growth and expansion.

Here is my full list of observations being a customer of Southwest Airlines:

My experiences with Southwest have given me the overall impression is that their business model favors simplicity, providing quality customer service, and offering straightforward fee structures. Now, how do those attributes stack up when compared to their competition?

When compared to the rest of the industry, it seems that the things I value most about Southwest are the things that make them unique within the airline industry.

Let’s have a look.

Simplicity

Let’s put Southwest’s simplicity into perspective. Southwest’s entire fleet consists of Boeing 737 planes. In contrast, the rest of the industry is nothing like this. For instance, United Airlines’ fleet features two different Airbus plane models, eight different Boeing models, and not to mention another six aircraft models in their express fleet.

The fact that Southwest maintains a fleet comprised of the one model gives them an advantage when it comes to maintenance, purchase contracts, and speed of repairs.

Another example of their simplicity is their in-flight service offerings. It might seem like limited drink options and no in-flight meals would be a negative, right? On the contrary, Southwest credits its industry-leading efficiency and turnaround times to its streamlined, simplified offerings. Their limited menu items mean they can restock the plane between flights in less time with fewer employees.

Where’s the first-class seating?

Southwest calculated that removing the excessively spacious first-class seating would allow them to increase seating space for all passengers onboard. This improves passenger comfort and appeases the majority of fliers who don’t plan to use first-class services anyway. Moreover, Southwest has calculated that the number of customers they alienate by not offering first-class seating is more than offset by the positive impressions it has formulated with its overall customer base.

Are Southwest flights really on-time more than their industry counterparts?

Yes, they are. Southwest flights depart and land at their destination on time 78% of the time. This is an impressive 8% higher than the industry average. Southwest leads the industry in on-time departures and arrivals by having gate-to-gate flights that don’t send their customers hundreds of miles in the opposite direction forcing them to race to their connecting flight before reaching their final destination. Eliminating what Southwest considers “unnecessarily” burdensome travel, limits the opportunities for things to go wrong. This means fewer delayed flights or missed connections and happier customers!

My customer service observations

I fly about ten times a year (partially for work), but I recognize that I’ll probably never get the full picture even with 80+ flights under my belt with various airlines. For that reason, I think it’s important to balance my first-hand experiences with Southwest’s customer service with some empirical data.

According to a 2017 study by JD Power, Southwest ranked number one in overall customer service by low-cost carriers. Ranking number one is great, but what really sets Southwest apart is their consistency. In fact, JD Power says that consistency plays a key role in inspiring strong loyalty from customers. Moreover, JD Power has opined that core repeat customers of value airlines like Spirit are so dissatisfied with their services that they are willing to pay considerably more to fly with Southwest. This type of data has led me to believe that Southwest’s commitment to high-quality customer service will inevitably benefit their bottom line.

Comparing Southwest’s fee structure to the rest of the industry

As the graph depicts, Southwest is the only airline that offers two free checked bags. In fact, Southwest is just one two companies that even offer the first bag free! Furthermore, Southwest is the only company with absolute fee forgiveness for changing or cancelling your flight.

Southwest is truly unique in their structure and remains profitable while doing so. For that reason, I’d conclude that such a distinction offers them a significant advantage in the marketplace.

What is the financial outlook?

At the time of writing, Southwest (whose NYSE stock symbol is LUV, how appropriate!) is trading for about $65 a share. Just five years ago, their share price was barely $11. It’s risen quite a bit. At this stage, we’ve missed out on an outstanding period of growth, but that doesn’t mean we should necessarily stay on the sidelines patiently awaiting a better entry point.

The overwhelmingly positive opinions about Southwest are no secret to investors, and therefore are priced into the stock. But like I’ve said before, it’s likely that approximately 30 months of insights and public opinion will show up in any given share price. That being said, Southwest has domestic and international expansion plans that will take another 5-10 years to unfold. Those prospects are not likely to be priced into the current share price and could aid in the stock’s intrinsic value.

The most common tool used to look at whether or not a share is expensive is the price-to-earnings ratio (P/E Ratio). Simply put, this ratio analyzes the earnings per share (EPS) and then divides that figure by the share price. Currently, Southwest is at about $3.50 EPS. And as I mentioned above, their share price is at about $65. This equates to a P/E Ratio of 18.50.

Note: For a crash course on understanding P/E Ratios, check out this article from the Military Dollar!

As the golden child of the airline industry, I expected Southwest to have a higher P/E ratio than its competitors. Here’s what I found: the average P/E Ratio of United, Jet Blue, Delta, and American Airlines comes to roughly $13. By that measure, Southwest would be considered an expensive stock to own within its industry. At the same time, that may be for good reason.

While Southwest’s high P/E Ratio is certainly noteworthy, I wouldn’t necessarily be scared off by that given all the optimism I have for Southwest.

Should I Invest?

Without a doubt, the should I invest or should I not invest part of the article always invites controversy. Like any other financial writer, I have no idea what will happen to Southwest’s share price over the next ten years. However, I can comfortably surmise that Southwest is a special company that has revolutionized the airline industry.

Financial writers around the globe have pessimistically cautioned that a company with only one aircraft model will undergo significant growing pains as they push into international travel. Offering international flights requires larger planes with more fuel capacity. Making a smooth transition into international travel could be tricky for Southwest. There’s also the possibility that governmental influence will push the airline industry toward using biofuels. This technology already exists and it won’t be long before we’ll know which airlines are best adapting to these technological changes. Southwest has not turned a blind eye to this inevitable event, as they have begun processing renewable fuel orders back in early 2014. Though they are beginning to address environmental issues, how this challenge will affect their profitability remains a question.

Ultimately, the entire airline industry has been considered a low profit dog-eat-dog business for some time. It wouldn’t be irrational for folks to decide to steer clear of the industry altogether. However, my personal opinion is that air travel has some recession proof elements. That’s why I’m not scared off by some of the concerns I just mentioned.

All things considered, I feel confident that Southwest would be a worthwhile investment option for a small portion of my portfolio.

CAUTION! BEWARE OF CONFIRMATION BIAS

The Achilles heel for grass roots investors can be the tendency for confirmation bias. There is so much data and statistical research online that it can be easy to search until you find something that supports your views and feel validated. In this case, I feel pretty confident that my research supports the belief that Southwest is a special company. Not all research yields such straightforward results, however.

A Few Final Thoughts

The grass roots investing approach, like any method for selecting individual stocks, is not a perfect model. Accountants and actuaries would be much more likely to apply more systematic models in order to remove subjectivity and emotion from their trading processes.

However, I’m a firm believer in buy and hold investing. I feel that investors are much more likely to buy and hold(emphasis on the hold) an investment after engaging in a thorough analysis rather than employing some abstract financial paradigm they don’t fully understand or believe in.

Although your investments may not always go as you hoped, I find that using a process similar to the one I outlined above makes it easier to accept the outcome, because for better or for worse, you can point to a system as justification for you investment decision.

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Hi, I'm Darian! I am a twenty-something insurance professional working on my ultimate quest for financial freedom. I hope you enjoyed this article. Stick around to learn more about financial strategies to manage debt, save more, spend less, and live the life you want.

2 Comments

I have a dirty secret to any Mustachian – I only hold about 1/3rd of my investments in an index fund. The rest is put into investments of my choice. I truly believe those willing to put in the effort can find stocks set to outperform the market.

Quite the dirty secret indeed! I think most who get into investing start to have the desire to steer their own ship a little at some point. If you do any case studies I would love to look them over. I’m always looking for new perspectives on that whole process. Cheers!